What causes financial crises? The causes of the global crisis of 2008-2009 have been widely analysed (see for example Eichengreen 2008), just as the Asian crisis was in the 1990s. As economists, we want to attribute crises to something like fraud, greed, cronyism, or misbehaviour of some kind. We want to think that if we can control misbehaviour, we can eliminate crises.

My recent work considers a very different hypothesis (Daniel 2012). Business investment is risky, and financial markets in emerging markets are weaker than they are in industrial countries. Financial crises in emerging markets can arise, not from fraud and greed, but as the downside of risky business investment projects financed by short-term debt in relatively weak financial markets.

When entrepreneurs must borrow in relatively weak financial market, bad news about the aggregate profitability of investment reduces the quantity of loans that creditors are willing to provide, creating a sudden stop in foreign lending, debt renegotiation, and private sector default.

I demonstrate that wealth and the strength of financial markets divides countries into three ‘credit clubs’:

Those in countries with intermediate levels of wealth and financial market strength have unstable access to foreign capital with volatile risk premia.

And those in countries with little wealth and weak financial markets have no access.

There is good news in this result. As emerging economies become wealthier and strengthen their financial markets, they should be able to join the club with stable access to capital.

Financial markets in emerging economies

I specify a theoretical model in which entrepreneurs have the opportunity to invest in profitable, but risky, long-term projects. Entrepreneurs have insufficient wealth to finance the projects and must seek financing from risk-neutral international creditors.

Financial markets are weaker in emerging markets than in industrial countries in two respects. Financial disclosure laws are weaker, implying that most financing takes the form of debt instead of equity. In the event of default, the bankruptcy court awards creditors a smaller share of the proceeds from the investment project.

When risky projects are financed by debt, creditors impose a ceiling on debt to assure that entrepreneurs with a profitable project prefer repayment to sacrificing the specified fraction of output in bankruptcy court. The larger the expected bankruptcy award, due to larger expected output and greater creditor protection, the higher is the debt ceiling. (Townsend 1979, Bernanke and Gertler 1989)

I also assume that only short-term loans are available, yielding maturity mismatch between debt and investment. One-period loans finance two-period investment projects. Maturity-mismatch is due to moral hazard, with the short maturity giving creditors greater monitoring ability. In the event of default on initial debt, entrepreneurs lose access to new loans.

Incentives for maximum debt and risk

In the initial planning period, each entrepreneur borrows to finance an investment project of fixed size with the objective of maximising utility of consumption over the next two periods. The loan must be large enough to finance the investment project, but it could be larger. Entrepreneurs are uncertain about the availability of loans in the coming period. If they could lose access to new loans in the future, then they have a precautionary motive to borrow in the initial period to support consumption in the period prior to maturity of the investment project.

In the middle period, initial debt is due and news arrives about aggregate profitability of the investment projects. Entrepreneurs receive little income from the project before it matures and therefore plan to increase debt to finance consumption and continuation of the project. International creditors set ceilings for new debt based on the news. If the news is bad, the debt ceiling is low. If the ceiling is so low that entrepreneurs cannot roll over initial debt, then they optimally choose default.

Since entrepreneurs lose access to new loans in the event of default, they have a precautionary motive to increase initial debt to support consumption in the middle period. However, the greater is initial debt, the greater is the probability that the ceiling will bind, yielding a greater probability of default. And the higher is the probability of default, the greater is the incentive to raise initial debt. Initial debt is driven to the ceiling, creating maximum risk.

These incentives to increase initial debt do not exist if the credit ceiling in the middle period never binds. Higher bankruptcy protection increases the credit ceiling, and higher initial wealth reduces initial debt. Therefore, wealthy countries with strong financial markets do not face the same incentives to increase risk.

Countries are divided into credit clubs based on wealth and the magnitude of bankruptcy awards. An entrepreneur who might lose access to credit prior to the maturity of the investment project has a precautionary motive to increase debt to the maximum amount, yielding maximum risk. This country belongs to the risky credit club. An entrepreneur in a country with high wealth and high bankruptcy awards belongs to the safe club. Other entrepreneurs with either so little wealth or such low bankruptcy protection that they cannot finance the investment project, even with debt at the ceiling, cannot borrow at all.

Financial crises

A financial crisis with widespread default occurs when bad news about future productivity reduces the debt ceiling so much that creditors cannot roll over debt. Default is widespread with many entrepreneurs whose projects will prove profitable choosing default.

I consider whether the analysis can match quantitative aspects of the 1997-1998 crisis in South Korea. I consider South Korea to belong to the risky credit club. I embed the model in a general equilibrium framework with overlapping generations of two types of economic agents: entrepreneurs who have access to risky investment projects; and others who earn a safe, small income. I calibrate parameters to match data for South Korea prior to the crisis. The quantitative analysis confirms the ability of the model to explain the crisis. It demonstrates that a crisis with observed magnitudes could have been the downside of risky investment projects, which were financed in markets with imperfections likely to characterise emerging market economies.